Bankruptcy, Not Bailout?

Many are saying that if we don't come up with a bailout package, that the economy will crash because of the lack of credit available to companies and consumers. Others are saying that a bailout of struggling companies by taxpayers isn't a good idea either, and that a plan involving insuring the troubled assets would be better.

I'm beginning to come down more on the side of the bailout not being a good idea.

Today I was reading an article on CNN by Jeffrey A. Miron, a senior lecturer in economics at Harvard University. He proposes that bankruptcy, not a bailout, is the best course of action for our current crisis. He explains the current mess:

This bailout was a terrible idea. Here's why.

The current mess would never have occurred in the absence of ill-conceived federal policies. The federal government chartered Fannie Mae in 1938 and Freddie Mac in 1970; these two mortgage lending institutions are at the center of the crisis. The government implicitly promised these institutions that it would make good on their debts, so Fannie and Freddie took on huge amounts of excessive risk.

Worse, beginning in 1977 and even more in the 1990s and the early part of this century, Congress pushed mortgage lenders and Fannie/Freddie to expand subprime lending. The industry was happy to oblige, given the implicit promise of federal backing, and subprime lending soared.

This subprime lending was more than a minor relaxation of existing credit guidelines. This lending was a wholesale abandonment of reasonable lending practices in which borrowers with poor credit characteristics got mortgages they were ill-equipped to handle.

The fact that government bears such a huge responsibility for the current mess means any response should eliminate the conditions that created this situation in the first place, not attempt to fix bad government with more government.

He goes on to talk about what he would propose instead of a $700 billion bailout:

The obvious alternative to a bailout is letting troubled financial institutions declare bankruptcy. Bankruptcy means that shareholders typically get wiped out and the creditors own the company.

Bankruptcy does not mean the company disappears; it is just owned by someone new (as has occurred with several airlines). Bankruptcy punishes those who took excessive risks while preserving those aspects of a businesses that remain profitable.

In contrast, a bailout transfers enormous wealth from taxpayers to those who knowingly engaged in risky subprime lending. Thus, the bailout encourages companies to take large, imprudent risks and count on getting bailed out by government. This “moral hazard” generates enormous distortions in an economy's allocation of its financial resources.

Thoughtful advocates of the bailout might concede this perspective, but they argue that a bailout is necessary to prevent economic collapse. According to this view, lenders are not making loans, even for worthy projects, because they cannot get capital. This view has a grain of truth; if the bailout does not occur, more bankruptcies are possible and credit conditions may worsen for a time.

Talk of Armageddon, however, is ridiculous scare-mongering. If financial institutions cannot make productive loans, a profit opportunity exists for someone else. This might not happen instantly, but it will happen.

Miron proceeds to explain how if a bailout passes, the chances of companies gaming the system to get as much of their piece of the bailout pie is likely to happen – and that he thinks much of the credit freeze that is happening right now is due to the chances of a bailout. Companies would much rather get 30-50 cents on the dollar for their troubled assets through a bailout as opposed to selling them for 20 cents on the dollar on their own.

He also talks about how he thinks that a bailout will likely benefit those in government and in special interests, solidifying the power of those in Washington, and not benefiting the taxpayers as much as we might think.

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He concludes the article:

Eliminate those policies that generated the current mess. This means, at a general level, abandoning the goal of home ownership independent of ability to pay. This means, in particular, getting rid of Fannie Mae and Freddie Mac, along with policies like the Community Reinvestment Act that pressure banks into subprime lending.

The right view of the financial mess is that an enormous fraction of subprime lending should never have occurred in the first place. Someone has to pay for that. That someone should not be, and does not need to be, the U.S. taxpayer.

A few days after the House rejected a similar $700 billion bailout plan, the Senate on Wednesday gave approval to a similar but slightly different…

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Comments

The article is dead-on about the relentless push toward home ownership. Home ownership rates rose 6% to record levels in 2007. Many of those new owners were unqualified. But, it was the politically correct thing to do. Ask Barney Frank.

I like where you are headed Pete. Fundamentally, I like that we rely on people not government to fix things. We are all to willing to give up our freedom to let government fix all the problems that can only truly be fixed by us(the people) doing something about out. Government should be on our side and enabling solutions, but not taking control wherever possible. We have options as people. Getting involved in government(voting and calling reps), picking what stores and what loans to shop at, getting out of debt and being responsible, and helping others. Our actions can and do influence things even if it takes some time and some unity.

I do agree that fear is the main thing that drives our motivation now a days and I don’t think it makes for very good decision making(usually short sighted and reactionary).

The more I read about a bailout, the less I like it. Now we have the senate about to re-introduce a bailout bill – with the main difference from the one that was just defeated being an increase in the amount of FDIC insurance. Why? what difference is that going to make – why would this one pass – and not the other?

Interesting point about opportunity. So US companies can’t give credit…Why not get credit overseas? Wouldn’t that be what a person does if they get a mortgage through ING? Credit wouldn’t be frozen forever. We’re just looking to save US firms that leveraged themselves too much.

I can see the point in raising the FDIC limit in general but I don’t see what it has to do with the bailout. It just puts more gov’t money on the line if a bank fails.

Yes, I agree with all the arguments you put forward but there is one thing you overlooked. You look at it from the viewpoint of just American interest. If the American government fails to restore the confidence of the world economic institutions, then the whole world economic system will collapse and there will be worldwide recession. You see the whole world economic system is so tied up with the American economic system that if the latter collapses, it will bring down the whole world economic system. That’s the price to pay for being an economic and political superpower. When America sneezes, the whole world gets cold. If The US reneges on this most important responsibility to the world, then some other nation would take the mantle of leadership and America will be reduced to a lameduck country running to a dark corner and licking its own wounds. In the end, there will be worldwide economic chaos and economic wars may be waged by power seekers and upstarts. Thanks for the post. God bless you always.

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